Why Discover Financial Is Worth $39

Discover Financial’s (NYSE:DFS) stock has climbed nearly 70% since the turn of the year, in-line with our expectations. The company’s revenues have increased 5% in the first nine months of the year, coinciding with growth in its card business. Complementing this growth in its core business, Discover has also branched out into other verticals such as mortgage and student loans, most notably through the acquisition of Citigroup’s (NYSE:C) $2.5 billion student-loan portfolio, last September.

Discover Financial is quite reliant on its credit card business. Interest from credit loans account for 66% of its net revenues whereas discount fees charged from merchants accepting its cards account for another 16%. So all in all, credit cards account for about 82% of the company’s revenues and around 80% of its gross profit. Discover had been able to maintain a high single digit yield, around 9%, on its outstanding loans in the last two years as well as industry low delinquency rates. We expect a nearly flat yield curve over the next few years.

As it accounts for such a high proportion of Discover’s gross profit, the company’s stock is highly sensitive to yield and could drop by as much as 20% should the yield fall below 7% by the end of our forecast period. You can gauge the effect of a change in yield by modifying the interactive chart below.

Discover charges discount and interchange fees from merchants on the basis of the dollar value of the transactions processed by the merchants. Facing regulatory restrictions and stiff competition from Visa (NYSE:V), MasterCard (NYSE:MA) and American Express (NYSE:AXP), Discover has had to cut its fees in the last few years but still saw revenue growth as its purchase volume increased.

The key drive to value is that we expect a steady growth in volumes as cards replace cash transactions worldwide. Visa estimates that over 30% of consumer spending worldwide is still carried out through cash and checks, accounting for $10 trillion in gross dollar volumes. This provides a huge potential market for Discover to capitalize on.

We believe that improving macroeconomic conditions and expansion both in the U.S. and worldwide will lead to sustainable growth in Discover’s purchase volume.

Diversification

Following the foray into student loans, Discover entered the mortgage business after acquiring the Home Loan Center from Tree.com, in June this year. The division wrote more than $1 billion in mortgages in the first 100 days of its launch. The student loan balance has gone up by 33% over the last year and the interest income on loans other than credit card loans has increased by nearly 50%. We expect Discover to build on the momentum it has gained in this domain leading to an increase in average other interest earning assets and consequently, income.

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